If you owe a number of years of income tax debt, Chapter 13 allows you to favor those taxes that have to be favored, while dumping the taxes that can be dumped.
In my last blog I gave an example showing how Chapter 13 can be an extremely good way to handle income tax debts particularly when you owe multiple years of taxes. In that hypothetical case, without a bankruptcy a couple would have had to pay about $30,000 to the IRS for back taxes, plus about another $45,000 in medical bills and credit cards, a total of $75,000. And paying this huge sum of money on their income would have taken them many, many years of pressure and uncertainty. In huge contrast, in a Chapter 13 case this same couple would only need to pay about $17,500, less than 1/4th the amount. And they would be allowed to do so through pre-arranged affordable monthly payments, for three years, all the while not having to worry about aggressive actions by any of their creditors, including the IRS.
How does Chapter 13 pull this off?
1) Tax debts that are old enough are lumped in with the lowest priority “general unsecured” creditors—like medical bills and credit cards—and so in many cases do not need to be paid anything unless there is enough “disposable income” to do so. This means that often those taxes are paid either nothing—as in the example—or only a few pennies on the dollar.
2) The more recent “priority” taxes DO have to be paid in full in a Chapter 13 case, along with interest accrued until the filing of the case, but a) penalties—which can be a large part of the debt—are treated like “general unsecured” debts rather than “priority” ones, and 2) usually interest or penalties stop when the Chapter 13 is filed. These can significantly reduce the amount of tax that has to be paid.
3) “Priority” taxes are paid in a Chapter 13 case before and instead of “general unsecured” debts. This often means that having these taxes to pay simply reduces the amount of money which would otherwise have gone to those “general unsecured” creditors. So sometimes, amazingly, having tax debt does not increase the amount paid in a Chapter 13 case. In our example, the couple paid about $500 per month for three years, which is the same amount they would have paid even if they did not owe a dime to the IRS! They met their obligations under Chapter 13 by paying the IRS instead of their other creditors.
4) The bankruptcy law that stops creditors from trying to collect their debts while a bankruptcy case is active—the “automatic stay”—is just as binding on the IRS as on any other creditor. The IRS can continue to do some very limited and sensible things like demand the filing of a tax return or conduct an audit, but it can’t use the aggressive collection tools that the law otherwise grants to it. Gaining relief from collection pressure from the IRS AND all the rest of the creditors is one of the biggest benefits of Chapter 13.
I confess that I put this example together in a way that would showcase the advantages of Chapter 13 in dealing with income tax debts. If the facts were different, the advantages could easily be less. If, for instance, more of the taxes were “priority” debts that had to be paid, the debtors would have to pay more, either through larger monthly payments or for a longer period of time. There are definitely situations where it is a close call choosing between Chapter 7 or Chapter 13, or possibly even not filing bankruptcy at all but doing an offer in compromise with the IRS. To decide what is best for you, you need the independent advice of an experienced bankruptcy attorney, who is ethically and legally bound to look out for your best interests. Regardless whether your tax debts and other circumstances point strongly in one direction or it’s a closer call, you need a professional qualified both to help you make an informed decision and then to execute on it.